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Daddy, Where Do High-Yield Dividend Stocks Come From?

Storks don’t deliver nice, healthy, fat-dividend stocks to mothers and fathers. High-yielding dividend stocks are not instantaneously created, and only a small number of them grow their dividends with “yield integrity,” a property I cooked up to identify the next responsible generation of high yielding stocks.

By now we know the story: The Fed is keeping rates down, and income oriented investors are hurting from a scarcity of cash flow instruments. Many American are focused on income generation. Naturally, your search for income has led you to high dividend stocks—equities that pay a large dividend while providing the holder with capital appreciation potential as well.

I’m a fan of dividend stocks, but I don’t necessarily rule out stocks that pay low dividends either—especially if I think they have potential to raise their dividend. Instead of only buying today’s top yielders, why not try to find low payers that may pay out later in the cycle? There is a much greater chance that such stocks may be underfollowed, because their low yield slips under a yield hog’s radar. They would “screen out” of a typical stock screen for high dividends, but what if some of those stocks are the next big dividend payers? Think of the extra value of getting in before everyone else recognizes the potential for dividend growth.

I search for the next generation of high-yielding dividend stocks by looking at past dividend growth rates. I also look at dividend payout ratios—the percentage of the earnings the company pays out as a dividend. A small payout means there is plenty of money to reinvest in the company for organic growth or other strategic initiatives. A big payout ratio can sometimes signal trouble. In some cases a company could simply run out of money by increasing its dividend while decreasing retained earnings. To me it comes down to an integrity issue.

Integrity in the investment community has become very important in evaluating management’s behavior and initiatives. Figuring out a way to measure a company’s commitment to constantly raising the dividend in a fiscally responsible way could help you rank the relative integrity levels of companies’ dividend policies.

My “Dividend Integrity Index” ranks companies according to their potential to sustain high dividend growth while keeping the payout ratio reasonable. The Integrity Index identifies companies that have promising increases in dividends while still honoring a low payout ratio as well. The Dividend Integrity Index simply divides the past 5 year dividend growth rate by the dividend payout ratio, and listed values greater than one. I set the lower cutoff of my Integrity Index to one, because I want the company to show dividend growth that has been at least as much as its current payout ratio. The higher the Index value the better, because it either has a high 5 year growth rate tempered by a fairly low payout ratio, or a modest growth history with a very low payout ratio.

The table below lists my results. I began with stocks that have an S&P quality ranking greater than B, debt to capital less than 50%, and market capitalization greater than $500 million. Starting with roughly 6,000 stocks, only 12 stocks have a high dividend integrity index greater than one:

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